I am the chairman of Revolution PAC as well as the president and co-founder of the Social Security Institute (along with Mike Korbey). I also serve on the Advisory Board of Gold Standard 2012. Previously, I was chief economist to Jack Kemp at Empower America, former staff director of the congressional Joint Economic Committee, former vice president and chief economist of the U.S. Chamber of Commerce and former Reagan White House adviser.

The Problem With Ron Paul's Magical Debt Extinguishing Wand

While discussing the U.S. debt situation with Iowa radio host Jan Mickelson recently, Texas Congressman and Republican presidential candidate Ron Paul suggested wiping from the books the $1.6 trillion in federal bonds owned by the Federal Reserve.

The Fed used its magic checkbook to create the money out of thin air to buy the bonds (aka “monetizing the debt” — the Fed has made somewhere between 70% to 85% of all Treasury purchases since its QE2 program began). Moreover, all the interest on the bonds that Uncle Sam pays the Fed ($79 billion last year) is returned to the Treasury anyway, so why not wave a reciprocal magic wand and simply eliminate the bonds and reduce the national debt by $1.6 trillion in one fell swoop? Paul put it this way:

We owe [the Fed], like, $1.6 trillion because the Federal Reserve bought that debt. . .We don’t, I mean, they’re nobody; why do we have to pay them off?

They’ll [markets will] say ‘Hey, they’ve just reduced the deficit [sic] by over a trillion dollars, now they can handle it. They can go back to meeting their other obligations.’ It might give some reassurance to the market.

The problem with Paul’s suggestion is that simply extinguishing the bonds doesn’t also extinguish the $1.6 trillion the Fed printed to buy the bonds originally, which now is dammed up inside the banks in a huge reservoir of liquidity because the banks have not been lending it out. This excess liquidity would be highly inflationary if (when) it flooded out into the economy as new credit, which it will eventually, if the economy ever recovers. Therefore, the Fed retains those bonds at the ready in its portfolio so that if (when) inflation begins to rise, it will have the bonds to sell back into the market to soak up that excess liquidity it created when it originally printed the money and purchased the bonds.

Recent evidence suggests seepage of liquidity into the economy may already have begun. The significant pickup in required bank reserves recently, which have grown at a 32% annualized rate so far this year, may mean the $1.6 trillion of reserves the Fed flooded the banking system with during the past several years are beginning to flow out of the banks. If banks are now lending out more and more of their reserves it means the Fed may soon have to begin soaking up some of the $1.6 trillion, i.e., selling bonds.

So, unless Paul’s idea is simultaneously implemented as part of his larger plan to eliminate the Fed altogether — which is a good idea but unlikely to happen anytime soon — markets likely would look askance at eliminating the Fed’s bond sponge, which it will eventually need to clean up the inflation mess it has set in motion. Many bond analysts are concerned that interest rates will spike and further exacerbate the federal government’s fiscal position when the Fed has to unload its bonds on the market.

There is, however, a variant on Paul’s idea that could be implemented immediately, which would have additional salutary effects beyond just reducing the national debt. Rather than defaulting on the Fed’s Treasury holdings as Paul suggested, Congress could legislate a mandatory swap with the Fed: Real assets owned by the U.S. government in exchange for all or part of the $1.6 trillion in federal bonds held by the Fed. (One study estimates that unused, surplus federal property alone could be sold for more than $1.2 trillion without even considering land, building, facilities, structures, equipment and other real assets currently in use by the government that could be put to more efficient use by the private sector.)

The Fed would hold the real assets short term in a custodial capacity, then when it came time for it to clean up after itself and soak up the liquidity it has flooded the banking system with, Congress could require the Fed to sell those real assets at public auction first, before any other assets on its balance sheet, and then extinguish the money receipts it brought in—a sort of monetary pullback function. By selling real assets rather than bonds, the Fed would be able to withdraw the inflationary excess liquidity without putting upward pressure on interest rates as a consequence of having to flood the market with federal bonds. Doing the swap with the Fed first rather than having the Treasury sell the assets directly would ensure that the money being withdrawn from the economy would be extinguished rather than spent by the government.

Swapping Treasury Bonds for government assets will not automatically reduce the outstanding national debt unless the Treasury Department were also to extinguish the bonds, which is possible. However, a better approach would be for Congress to instruct Treasury to swap the full-faith-and-credit federal bonds it received in the real-asset swap with the Fed for an equivalent amount of special-issue, non-marketable federal bonds currently held in the Social Security Trust Fund, which would be extinguished instead.

This second swap would accomplish two things at once: 1) It would reduce the outstanding national debt by up to $1.6 trillion because the special-issue Trust Fund bonds being extinguished count as part of the national debt; and 2) It would replenish the Social Security Trust Fund with real, marketable assets.

When the Social Security Trust Fund has to be tapped to make up for annual shortfalls in Social Security payroll taxes, the Treasury would not have to borrow more money from the public to redeem Trust Fund bonds as it does currently with the non-marketable, special-issue bonds held by the Trust Fund; it simply would sell to the public full-faith-and-credit bonds that now were being held as assets in the Social Security Trust Fund in an amount sufficient to generate enough cash proceeds to cover the payroll-tax deficit. This transaction would not constitute new borrowing; it would consist of asset sales.

Post Your Comment

Post Your Reply

Forbes writers have the ability to call out member comments they find particularly interesting. Called-out comments are highlighted across the Forbes network. You'll be notified if your comment is called out.